What Drives Housing Cycles?

7/10/2008

It's no secret that the U.S. housing market is cyclical and in the midst of yet another painful correction. The causes and characteristics of these cycles vary, at least in some respects, but the implications for homebuyers, home sellers and homeowners remain remarkably reliable as the cycles roll by.

Housing cycles aren't all alike, yet over long periods of time a basic pattern can be discerned, says Mark Dotzour, chief economist of the Real Estate Center at Texas A&M University.

A cycle doesn't really have a start or a stop, but to pick a point at random, we might say that a housing cycle "starts" when economic activity heats up and interest rates rise. Higher interest rates make housing less affordable, so demand decreases and home prices fall. Then, as economic activity slows and interest rates decline, housing again becomes more affordable and, consequently, demand and prices go up. Then the cycle repeats. Housing tends to lead the economy and thus can be an indicator of future economic activity.

Subprime Loans Goosed Demand For Housing

The severity of the current housing cycle has been exacerbated, Dotzour explains, by two factors:

Lenders flooded the housing markets with subprime loans that enabled borrowers who had poor credit to purchase homes they otherwise wouldn't have been able to afford. These risky loans were then securitized and sold to investors. Demand outstripped supply and prices rose too fast.

When these risky borrowers weren't able to pay back their loans, the lenders cut off the easy credit. Builders, who had expanded to meet the new demand, couldn't stop building new homes fast enough to match the sudden disappearance of buyers. Supply exceeded demand and prices dropped too quickly.

"In this cycle, we had a real abrupt change in demand (because) a certain segment of the homebuying public, mainly subprime and Alt-A buyers, were just completely shut out of the market overnight," Dotzour says. "Then what happens is that you get too much inventory and prices go soft."

Exuberant Investment Added To Housing Market Frenzy

Speculation by investors and homebuyers' expectations of a major financial payoff also make housing more volatile than other economic sectors, says Nicolas P. Retsinas, director of the Joint Center for Housing Studies at Harvard University. This factor can be represented along a continuum between consumption, or the purchase of a home primarily for personal use, and investment, or the purchase of a home primarily to generate a capital gain or profit.

Phoenix and Las Vegas are good examples of speculative markets in the current cycle, Retsinas says. In 2006, more than 30 percent of the homes sold in those two cities were purchased by investors rather than homeowner-occupants. Both cities had experienced rapid price appreciation and accelerated new-home construction, which were followed by sharply higher foreclosure rates.

Housing cycles can be challenging for people whose jobs are directly related to the volume of home sales or mortgage originations. In the two decades from 1980 to 2000, there were approximately 620,000 to 820,000 Realtors in the United States. That figure jumped from approximately 750,000 at the end of 1999 to more than 1.3 million last August, according to a recent commentary by Lawrence Yun, chief economist of the National Association of Realtors, or NAR. Due to last year's downturn in home sales, the association's membership "now is turning sharply lower," Yun wrote.

U.S. mortgage companies, which hired like crazy during the mortgage boom of the early 2000s, shed more than 111,000 jobs in the 12 months that ended Feb. 29, 2008, according to U.S. government data. More than 14,000 jobs were lost in the first quarter of this year alone, according to an industry newsletter. Large numbers of construction jobs have disappeared as well.

How Supply And Demand Work

Housing markets are cyclical because "the relationship between supply and demand is not in equilibrium," says Retsinas. This lack of equilibrium results in booms and busts that recur in cyclical patterns of varying duration.

A real estate boom, or "seller's market," occurs when buyers want to purchase more homes than are for sale at current prices. These top-of-the-cycle markets typically are characterized by rising prices, multiple offers, fast sales, easy financing and expansion in new home building.

A real estate bust, or "buyer's market," happens when more homes are for sale than buyers want to purchase at current prices. Characteristics of these bottom-of-the-cycle markets typically include falling prices, slower sales, financing and affordability constraints, short sales, foreclosures and a contraction in new home construction.

Home Prices Turn Up And Down Over Time

U.S. median home prices have climbed steadily upward each decade for at least the last 40 years. In 1987, for example, the national median was $85,600. Ten years later, in 1997, the median was $126,000, and 20 years later, in 2007, the median was $219,000, according to the NAR. But home prices also experienced a severe downturn in the early 1990s and, most recently, a major boom in the mid-2000s.

Prices naturally fluctuate from month to month due to seasonality and other factors. Median prices are a relatively crude instrument, because they aren't adjusted for inflation, lump numerous local markets into broad geographical areas and don't account for variations in the mix of homes sold, a weakness that can tilt the median upward or downward. Nonetheless, median prices often are looked to as a broad measurement of housing market trends.

The chief risk that cyclicality poses for homebuyers and sellers is that local home prices may fall further as the cycle deteriorates.